Fund manager: Plenty of reason to be cautious now

BOSTON -- The Appleseed Fund is unusual, and not just because of its strict socially-responsible investing mandate.

Just as noteworthy is Appleseed's atypical record. The mutual fund has been one of the best performers over the latest 5-year period, yet among the worst over just three years.

One reason Morningstar analysts give the fund a bronze-medal rating is its nearly 7 percent average annualized return over five years, a period that includes the 2008 stock market meltdown. That result puts Appleseed (APPLX) in the top 2 percent among mid-cap value stock funds.

Yet over just three years, 96 percent of those peers have done better than Appleseed's average 6.2 percent return.

Co-manager Adam Strauss says the disparity is a product of the fund's defensive approach to investing, which can help or hinder performance depending on the market's direction. It provided a big cushion in 2008 when Appleseed lost about half as much as the Standard & Poor's 500 index. Yet the fund badly trailed the market two years later, and it's having another off year as stocks continue to rally in 2012.

A key reason is the substantial amount of the portfolio that Appleseed's managers have kept out of the stock market the past few years. The fund recently held about 17 percent in gold and almost 14 percent in cash, with the rest in stocks that pass the fund's socially-responsible screening criteria.

That strategy could continue to hurt performance if stocks keep rising. One factor that's kept the rally going is the Federal Reserve's third round of bond-buying to stimulate the economy. The Fed's approval last month of the program known as "QE3" fueled short-term optimism for stocks. But there's also fear that it could eventually trigger runaway inflation.

That risk is a major factor in Appleseed's cautious outlook, including its stakes in gold and cash. In a recent interview, Strauss discussed concerns about QE3, as well as consumer debt levels that he says pose a greater risk to the economy than government debt. He also offered insights on stocks that could beat the market if inflation spikes. Here are excerpts:

Q: What's your take on QE3?

A: It's highly inflationary. It's hard to know when money goes into the system where it's going to go _ whether it will be used to buy gold, or stocks, or bonds, or to increase wages, or inflate housing prices or technology stocks. The Federal Reserve can't control what becomes inflated. So far, the stock market and commodity prices have inflated the most. Wages remain down.

A: We consider how a company would perform in an environment where costs are going up rapidly, including energy. In some cases, we're looking for an extra discount in the stock's price because of those factors, and sometimes we're looking at a company that could potentially benefit from those factors.

Q: What's an example of a stock in Appleseed's portfolio that could perform well if inflation spikes?

A: Shimano, the Japanese bicycle components maker. With high inflation and rising energy costs, lots more commuters will choose to use bicycles. So we're bullish about the bicycle industry. Shimano was very cheap when we first bought the stock a few months ago, and it's gone up significantly since then. It's a great brand, with terrific customer loyalty.

Q: Food prices have been rising faster than inflation in recent years. The fund's most recent top holding is Tesco PLC, the leading grocery chain in the United Kingdom. Can it withstand higher inflation?

A: Unfortunately, food prices are rising and will continue to rise. Grocery chains such as Tesco will benefit. At the same time, its price-to-earnings ratio is near an all-time low, and the dividend yield is more than 4 percent.

Grocery chains are in better position to increase prices than companies in other industries. You can cut other expenses in order to put food on your table, but people have to eat. In countries like Egypt, you can't pass on food price increases to consumers as much, or you get riots in the streets. In the U.K. and U.S., food is a lower proportion of the overall economy. So there's a lot of room to increase food prices. I'm not saying I'm happy about that, but it's where we are today.

Q: Why do you think consumer debt is a bigger problem than government debt?

A: The level of consumer debt is way, way too high for the size of our economy. There's lots of discussion now about government debt, but private household debt is a far bigger problem.

Q: If household debt is so high, what do you make of the recent reports indicating consumers are getting a better handle on credit card debt, and are increasingly paying balances on time?

A: There has been a very small amount of household deleveraging. There's still a lot more that has to happen. Part of that should happen from consumers restructuring their debts. But this process has been slow because the "too big to fail" banks are reluctant to write off bad loans which would weaken their balance sheets. So that's why the much more likely outcome is going to be inflation. Prices will be inflated so that gross domestic product seven or eight years from now will be two times what it is today. Then the old debts become a much lower percentage of GDP.

Q: What's the Fed's role in this?

A: Policymakers came to the conclusion years ago that the only politically feasible solution to the problem of excessive debt was an inflationary solution.

Whether QE3 is the right thing to do is the wrong question. The mistakes that were made that caused the Fed to approve QE3 occurred back when the housing bubble was forming. Now this is sort of a predictable outcome that the Fed is printing a lot of money to inflate us out of this debt.